Introduction of Short Selling
Short selling is an advanced trading technique used by traders or investors or portfolio managers as a medium of speculation or medium of hedge against downside risk for the same stock or any other, which helps the traders to gain from a decline in the price of the stock from the price at which the stock has been sold.
- Let me take you to the layman meaning of the word “short selling”. Suppose you have a purchased a stock @ $ 100. After sometime, you will sell the stock at profit/loss. This selling is done after you have purchased the stock (i.e. first you “bought” the stock, then you “sold” it).
- What if I tell that, you first need to “borrow” the stock from a person for a specified period & then “sell” the stock immediately. At the maturity date, you will purchase the stock from the market & return it back to the lender. For such lending, you the lender for “stock lending charges”. It is like taking a loan for a period & repaying with the principal amount with interest.
- Thus, normal selling means “buy & then sell”. Short selling means “borrow, sell the stock & then buy”.
- This strategy is used by portfolio managers for hedging themselves from the downside risk of movement of stock prices. Also, speculators used this advanced trading strategy as a medium of speculation & to gain from price movements.
- So, short selling is used for both intra-earners & medium-short term investors.
- So basically, short selling is involved where a person borrows stock or any other financial instrument which he believes will observe a decrease in price in the future. So, it is a downside bet.
How Does It Work?
The flow of short selling can be explained easily through the following steps:
Step 1: Borrow
Here you will first borrow the stock from a lender of stocks. Lender of stocks are normally big financial institutions. You can get these stocks through a stock broker easily. After you have borrowed the stock, you only have the possession of stock & not its ownership. You will have to return the stock after the specified period is over (say 2 months) along with stock lending charges.
Step 2: Sell
You have to immediately sell the stock, which you have borrowed. But one may ask “how can you sell something which you don’t own?” Well, that’s how short selling works. You just have to wait till the stock is available in the market at a lower price. But make sure that you have to return the stock within the specified period only (i.e. 2 months)
Step 3: Buy
In case the stock is trading at a lower price than what you sold at, you should purchase the stock. Here, you earn gross profit i.e. selling at a higher price & buying at a lower price. What if the price has not gone down within the specified period? This is the loss situation where in you will have to purchase the stock at maturity date at the available price (may be higher than what you sold at). In this case, you have to suffer gross loss.
Step 4: Return
At maturity, you have to return the stock by buying from the market along with stock lending charges. The lender is not concerned at what price you bought & returned it back. The stock lending charges are deducted from gross profit to arrive at a net profit due to short selling transaction.
Example of Short Selling
Say a stock is trading at $ 720 now. The company is about to post it’s June 2020 quarterly results by end of the month. Observing the Covid scenarios, the company is expected to post negative results. He wishes to earn by short selling. He is expected the fall by a minimum of 15%. He will close the position at a 12% downfall irrespective of the actual fall later on.
|Number of shares||100|
|Deposit with broker||$72,000|
|Price after 1 week||$612|
|Buy price of trader||$634|
|Stock lending charges per day||$90|
|C||Profit per share (A-B)||$86|
|D||Number of shares||100|
|E||Gross Profit (D*E)||$8,640|
|F||Number of days until buy||35|
|G||Stock lending charges per day||90|
|H||Charges paid (F*G)||$3,150|
|I||Net Profit (E-H)||$5,490|
- If you observe, the amount of investment made is NIL (i.e. zero). The deposit is refundable & taken as security.
- The trader will his bank account credited with $ 5490 after deducting nominal broker charges.
Short Selling in Share Market
We will divide our discussion in two practical parts of the share market.
1. Short Selling in Spot Market
Ø The trader first identifies the stock which will decline at least by 2% in coming period as per the technical analysis. The trader choses to short the stock by observing various parameters such as downside confirmation of indicators, risk & reward strategy holding good, the volume is above average, resistance level, etc.
- In the trading platform, you just need to sell the stock directly by entering the details such as quantity & price & hit the submit button. This opens a short position for yourself.
- Your expected directional move is a downside. If your stock moves upwards, start making a loss. So as to avoid risk, it is suggested to specify the amount of loss that can be borne by you i.e. specify the price at which the stock will be automatically bought in the market so that you do not incur more loss due to its upside move.
2. Short Selling in Futures Market
- The spot market has some restrictions in shorting the stock. There are no such restrictions in the futures market & this is the reason why the futures market is more famous. Futures just replicates the movement in stock price & thus it is a derivative instrument.
- In futures, there is a requirement of a margin deposit. The futures are marked to market on daily basis & adjusted with margin money.
- In a futures market, you short the futures of the said stock & this makes it more volatile in nature. Futures & Options are volatile by nature. This will amplify your return whether positive or negative.
Some of the advantages are given below:
- The biggest advantage is that you can earn profits without owning the stock.
- They earn directly the difference in prices without making any investment. Thus, there is no or minimal investment.
- You are liable to pay only the stock lending charges which are minimal.
- Since short selling is done using margins, this multiplies the returns you earn.
- It is easy to conduct short selling through open a trading account with a stock broker & you do not need to search for a lender.
- In case of multiple bad news, the stock price can move downside substantially & this can multiply your profits.
- This is bread & butter for speculators.
Some of the disadvantages are given below:
- As you know, short selling can be done only for the specified time (usually less than 6 months). You cannot hold the open short position for life long & wait for the downside of stock.
- Whatever be the price, at maturity you have to return the stock. Most stock brokers automate this process to ensure the delivery of stock to the lender on the maturity date. So, if such stock is available at high price on the maturity date, you have booked a loss.
- You have to pay stock lending charges for the period of holding. Some brokers charges hidden fees for such transaction. So, a trader needs to be aware of the same.
- In case a dividend has been earned on the stock, you have to transfer the dividend amount to the owner of the stock.
- The stock lender may demand the stock in before the maturity date & no one can stop him. In such case, you are required to purchase the stock & return the same to the lender at any cost. This is the biggest risk with short selling transactions. Thus, clear agreement is necessary.
- Stocks normally do not fall below their fundamental price. Even if it falls, it bounces back rapidly. Thus, by nature the stock can move upside without any limit. This means there is no limit on how much loss you may have to book during the lending period.
Short selling is viewed differently by speculators, traders & investors. It has a high magnified of returns. By returns, we mean both upside & downside return. So, it depends on the risk appetite of the person. High risk takers are rewarded high. Short selling is a short phenomenon in terms period of lending is concerned. Thus, investors prefer short selling only for a short duration of time.
This is a guide to Short Selling. Here we also discuss the introduction and how does short-selling work? along with advantages and disadvantages. you may also have a look at the following articles to learn more –